When Micro Prudence Increases Macro Risk: The Destabilizing Effects of Financial Innovation, Leverage, and Diversification

Fulvio Corsi (), Stefano Marmi () and Fabrizio Lillo ()
Additional contact information
Fulvio Corsi: Dipartimento di Scienze Economiche, Università Ca’ Foscari, Venice, Italy and City University of London, United Kingdom
Stefano Marmi: Scuola Normale Superiore, Pisa, Italy
Fabrizio Lillo: Scuola Normale Superiore, Pisa, Italy

Operations Research, 2016, vol. 64, issue 5, 1073-1088

Abstract: By exploiting basic common practice accounting and risk-management rules, we propose a simple analytical dynamical model to investigate the effects of microprudential changes on macroprudential outcomes. Specifically, we study the consequence of the introduction of a financial innovation that allows reducing the cost of portfolio diversification in a financial system populated by financial institutions having capital requirements in the form of Value at Risk (VaR) constraint and following standard mark-to-market and risk-management rules. We provide a full analytical quantification of the multivariate feedback effects between investment prices and bank behavior induced by portfolio rebalancing in presence of asset illiquidity and show how changes in the constraints of the bank portfolio optimization endogenously drive the dynamics of the balance sheet aggregate of financial institutions and, thereby, the availability of bank liquidity to the economic system and systemic risk. The model shows that when financial innovation reduces the cost of diversification below a given threshold, the strength (because of higher leverage) and coordination (because of similarity of bank portfolios) of feedback effects increase, triggering a transition from a stationary dynamics of price returns to a nonstationary one characterized by steep growths (bubbles) and plunges (bursts) of market prices.

Keywords: systemic risk; diversification; leverage; endogenous risk; financial innovation (search for similar items in EconPapers)
Date: 2016
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (32)

Downloads: (external link)
http://dx.doi.org/10.1287/opre.2015.1464 (application/pdf)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:inm:oropre:v:64:y:2016:i:5:p:1073-1088

Access Statistics for this article

More articles in Operations Research from INFORMS Contact information at EDIRC.
Bibliographic data for series maintained by Chris Asher ().